The 10th Man

How to Build a Bond Portfolio

August 29, 2019

Since I started this 10th Man bond series, you guys seem to be split broadly into two camps.

On one side, there are people who remain anti-bonds. Or at least, anti-investing-more-in-bonds.

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On the other side, there are the “yes, but” folks, who get why it’s important but feel blocked from doing much about it, for different reasons.

Anyway, as I said last week, we’ll be throwing you a lifeline soon. I’m working on something pretty important that is a) going to make bond investing a lot easier and b) be beneficial even if you’re anti-bonds (yes, really).

For now though, let’s continue with an article based on a question I’m getting from lots of you: how would you build a bond portfolio?

Best Practice

The best way to build a bond portfolio is to start by thinking about the risks.

A portfolio of bonds can go down, you know.

Yes, I know that US Treasurys cannot technically default (or at least, they haven’t so far). But they can decline in price, and the decline can be substantial.

For example, if long term interest rates go up a lot—say 2% or so—the price of a 30-year Treasury bond could drop by as much as 40%. That’s a scary number. Most people aren’t worried about that right now. They may be someday.

So we are definitely concerned about the direction of interest rates, known as duration risk. For US Treasury bonds, that is pretty much the only risk.

For other types of bonds, there are other risks. Corporate bonds can and do default. They haven’t in a while, but they will someday. More importantly, the price of these bonds will decline as the market perceives companies to be less credit worthy. In the investment community, this is known as spread widening. The spread between corporate interest rates and Treasury interest rates will widen.

In the last credit meltdown in 2015, led by energy credits, high yield spreads widened to about 700 basis points over Treasurys.

That’s a bunch of gobbledygook to many people. What does that mean to me as an investor in a bond mutual fund?

Well, if you own a high-quality investment grade corporate bond fund, the most it can probably go down because of credit concerns is about 5-7%. If it is a fund that is concentrated in BBB credits, perhaps a bit more.

If you own a high yield bond fund that focuses on BB credits, your downside is probably capped at around 20%. If it owns mostly speculative CCC credits, you could lose 30% or more. This is also true for convertible bond funds.

With international bonds, it is very much dependent on the situation, but emerging market bonds tend to be very economically sensitive and the downside could be large if we have a global recession.

Mortgage-backed securities are pretty boring most of the time, except in 2008, or if interest rates rise rapidly.

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One day, municipal bonds will be very, very exciting. Although people have been saying that for 15 years or more.

Now that we know the risks, let’s build a portfolio.

First Things First

What is your income? If it is north of $300K-$400K, you will want to consider owning lots of municipal bonds. Yes, I’ve heard all the arguments against munis—unfunded public pensions leading to muni bond defaults, blah blah blah. Maybe that is an issue in the next recession. Maybe not.

For the rest of the portfolio, you will want a mix of Treasury and corporate bonds. With yields this low, people are tempted to massively overweight corporates. I understand that sentiment.

By the way, one thing that is poorly understood about investment grade corporate bonds is that they are also very sensitive to interest rates. When Apple issued their first bonds back in 2013, people were surprised to see 10% of the value evaporate in a month—all on duration.

High yield bonds have a little exposure to interest rates (especially with the low coupons these days), but not much. Mostly, they are correlated with stocks.

So:

Treasury—all interest rate risk.

Investment grade corporates—some credit risk, some interest rate risk.

High yield corporates—mostly credit risk (they behave like stocks).

I don’t have a rubric here for what you should do, but your instincts on this—to overweight corporates to get more yield—are probably bad. This is actually the wrong time to be reaching for yield.

It’s the right time to be reaching for safety. Had you done so 8 months ago, you would be pretty happy today. Treasury bonds are up over 20% this year.

Maturity Matching

The other thing you need to consider when building a bond portfolio is the length of maturity you want.

Short-term bonds = less interest rate risk and less credit risk.

Long-term bonds = more interest rate risk and more credit risk.

You could just do it naively and pick a range of maturities. I’m not going to talk about it here, but you might want to do some research on bond laddering, the idea of which is to spread your risk along the interest rate curve.

The school of thought is that you want to match your bond maturities with your liabilities.

If you are going to retire in 30 years, you probably want 30 year bonds. If you are going to send a child to college in 10 years, you probably want 10 year bonds.

If you have a view on interest rates, that can help. For example, I think that the Fed is likely to cut rates to zero and beyond. This would make shorter maturities more attractive.

Once you put together your portfolio, you can figure out the weighted average maturity. A typical bond portfolio has a weighted average maturity of 5-7 years. If you are worried about interest rates or credit, you can make it shorter, or vice versa.

More Art Than Science

The key here is diversification. A portfolio full of municipal bonds will expose you to, well, the idiosyncratic risk that muni credit blows up.

And yes, this is more art than science.

And I know it’s not straight-forward. One reader said this recently: “I went into bonds hoping to ease up on time needed on my portfolio, but now I think shares are simpler!”

He’s not wrong.

But the bond market is much larger than the stock market. For many reasons, it is not clever to avoid it altogether.


Jared Dillian

 

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Comments

18343370

Sep. 1, 5:04 p.m.

If interest rates are going to zero or below, why is that good for shorter maturities? It would seem that buying 10yr treasuries at today’s yield would result in much higher bond prices when the yield goes to zero. I would not think shorter maturities would enjoy the same bond price appreciation. Mjlock80@gmail.com

rhammer@suddenlink.net

Aug. 29, 5:30 p.m.

Jared,
I believe Jack Clapper (see his comment)  is correct. Possibly a typo on your part.
- Richard

postdodson@gmail.com

Aug. 29, 4:13 p.m.

I would be very interested in the demographics of your readers.  I would think that greatly impacts many of the recommendations you are making.  I am retired and since I have no earned income cannot defer taxes in an IRA so Munis make no sense to me (unless I missed something in your article).  I have a Roth that i’ve been drawing on but next year the RMDs start and my minimum (plus SS) will be more than I need to live so the value of the Roth will only be to my heirs.  I’m almost entirely BBB investment grade (small HY as result of downgrade) and average maturity less than 8 yrs.  I’m happy as a clam but worry when you tell me I should worry.  Does one size fit all in your style?

pietro@autodataitalia.com

Aug. 29, 11:23 a.m.

Jared,count me in on the agaist camp.
For me bonds are, call me old school, the safe part of a portfolio which should provide income i.e. remunaration for the use of my hard-earned savings.
You are urging clients to speculate on bonds. That’s because you were a bond dealer.
For most of us receiving no remunaration comes with the risk of loosing a lot.
Stocks are easier and I prefer cash to bonds. Yes, no possible big gaines ( or losses!) but I only lose to inflation and I have it ready when needed.
If there were some remunaration I could hold until maturity but do I want to wait 10 or 30 when I know that whatever little eald will pale in comparison to real inflation?
Thanks for your inputs, however.

jack clapper

Aug. 29, 10:38 a.m.

I don’t understand your conclusion - “If you have a view on interest rates, that can help. For example, I think that the Fed is likely to cut rates to zero and beyond. This would make shorter maturities more attractive.”

If the Fed cuts rates to zero in the near future, buying longer term bonds now, prior to a rate cut, would result in the bond holder receiving a higher interest rate for the duration of the bond than the new lower rate. Buying a short term bond would result in the bond maturing and then having to replace it at the new lower rate. What am I missing?

joan casson

Aug. 29, 9:53 a.m.

you might want to explain the meaning of YTCall and the resultant interest rate re par or discount bonds. Also, for those of us that live in State with a significant income tax ratem Treasurys income is exempt from State income tax

jc